Related Unit: IB Economics Unit 4.7 – Balance of Payments (Unit 3.3 in the new IB Economics syllabus)

Topic: The Marshall Lerner Condition and the J-Curve

Learning Goals/Objectives:

• For students to understand that the levels of price elasticity of demand for a country’s imports and exports determines whether a depreciation or devaluation of the country’s currency will move the nation’s balance of payments towards a surplus or a deficit.
• For students to understand the impact of time on the effect of a depreciation or devaluation of a nation’s currency on its balance of payments in the current account.
• For students to evaluate the argument that a country will always benefit from a weaker currency.

Test of prior knowledge:

1. Define ‘price elasticity of demand’ and explain how it is measured.
2. With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
3. Explain how the depreciation of a country’s exchange rate might affect its current account balance. IS THIS ALWAYS THE CASE?
4. How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?

Process:

• Each student should research the forex market for his or her home country in the United States. If you are American, research the forex market for the dollar in Europe.
• Complete three pre-readings:
  • From BizEd:
    The Marshall Lerner Condition and The Economic Effects of a Devaluation
  • From Welker’s blog: The Marshall Lerner Condition and the J-Curve
    
• Using Yahoo Finance, research exchange rate data from the two countries two years ago up to today.
• Use Yahoo’s software to create two a line graph plotting the value of your currency in terms of dollars. For your initial graph, show the exchange rates over a two year period. For example:

The exchange rate of Japanese Yen in the United States over the last two years:

Next create a Google Doc (shared with your teacher)  of your answers to the following questions. Include in the presentation the graph of the exchange rates created in the step above.

Questions to answer in your Google Doc:

1. Create a graph of your currency’s exchange rate in the US over the last two years. Take a screen shot and save it to your computer as an image. Insert the chart into your Google Doc. Write a one paragraph description of the changes in your country’s exchange rate over the last two years. (2 marks)
2. Focus on two specific time periods from during the last two years: One in which your currency appreciated noticeably and one in which it depreciated noticeably. These  could be periods of just a couple of days or longer periods of weeks or more. (4 marks)
   • In Yahoo Finance, narrow the range of dates shown on your chart to the distinct period in which your currency strengthened and another period during which it weakened. Take a screen shot of the new graphs you’ve created, save them to your computer and upload them into the Google Doc.
   • Under each new chart, describe what is happening to the value of your currency in the two periods identified.
3. Beneath your two new graphs, explain TWO factors that may have caused the currency to change in value. (2 marks)
4. Given the changes to the exchange rate you identified above, what would you predict would happen to your country’s current account balance over the two periods identified? Explain. (4 marks)
   • Following appreciation (2 marks)
   • In the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run
   • In the long-run
   • Following depreciation  (2 marks)
   • In the short-run
   • In the long-run:
5. For both the period of appreciation and the period of depreciation you identified above, explain the impact of the change in exchange rates on the following (4 marks)
• a firm that imports its raw materials from the other country
• a firm that exports its finished products to the other country
• consumers who buy imports from the other country
• a firm that produces good for the domestic market and competes with firms from the other country
6. Why does the price elasticity of demand for imports and exports increase over time following a change in a country’s exchange rate? (2 marks)
7. Why will a depreciating currency worsen a country’s current account balance in the short-run? Assuming the currency remains weak,  how would the current account balance change over time. (2 marks)
8. Draw a J-Curve showing the likely change in your nation’s current account balance following the period of depreciation of its currency shown in your chart above and explain its shape, referring to your country’s currency. (2 marks)
9. Read the following article:  ‘How Far Will the Dollar Fall?’ by Richard W. Rahn. Based on the extracts below, answer the questions that follow.

Some applaud the dollar’s fall because they believe it makes U.S. exports less expensive and that higher demand will cut the trade deficit. The downside of a low-value dollar is that it makes all the imports we consume more expensive, including raw material and parts used by U.S. businesses, and makes it costlier for U.S. dollar holders to travel or invest outside the U.S. A continued drop in the dollar’s value could destabilize the international economy, leading to a worldwide recession.

• Why might the weaker dollar worsen the US trade deficit? Under what conditions would the weaker dollar improve America’s trade deficit? (2 marks)

Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar’s value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit.

• How does a large financial (capital) account surplus allow the United States to maintain a large current account deficit? (2 marks)

The world now is actually on a two-currency standard — the dollar and the euro. China in effect has fixed its currency to the dollar for the last two decades, and the Japanese central bank only allows the yen to fluctuate within a limited range against the dollar.

• How do exchange rate controls by China and Japan reduce the likelihood that a weaker dollar will improve the United States’ current account balance? (2 marks)

So long as the U.S. continues to offer a higher return on capital than its foreign competitors, both foreign banks’ and private investors’ demand for dollars grow, and the current account deficit can be sustained.

• If investments in the United States began earning lower returns relative to investments in other countries’ financial and capital markets, what would ultimately happen to the US balance of payments in its current and financial accounts? Explain (2 marks)

Total 30  marks – You have two class periods to work on this assignment. It will be graded as a “coursework” grade and counted towards your semester 1 report. To earn full marks, it must be completed by the end of the second class period.

The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”

The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

Have a look at this article before reading the blog post below: Pasta prices rise after North Dakota loses million acres of wheat to heavy rain, flooding – Associated Press

Prices are determined by the relative scarcity of a good, service or productive resource. This fundamental lesson is one of the first things we learn in a high school economics class. Why are diamonds, which nobody really needs, so much more expensive than water, which everyone needs? The answer lies not in the relative demands for the two goods (clearly, water is far more demanded than diamonds), but rather the relationship between the relative demand and the supply. Between the two, diamonds are far more limited in supply than water, thus they are scarcer and accordingly more expensive.

This lesson applies not only to water and diamonds, but indeed to any product for which there is a market in which buyers and sellers engage in exchanges with one another. Commodities are goods for which there is a demand,  but for which the supply is standardized across all markets. For instance, bicycles are not a commodity, because there are hundreds of different types of bicycles, meaning it is not a standardized product. But steel, which is used to make bicycles, is a commodity since steel is fairly standard regardless of its ultimate use by manufacturers. Cookies are not a commodity, but wheat is, since wheat is a highly standardized ingredient used in the production of cookies.

Commodity prices, like the prices of anything, are determined in markets. Buyers are usually the manufactures of secondary products for which the commodities are an input. Since commodities are traded all over the world, there tends to be a common market price determined by the national or international supply and demand for the commodity. In recent weeks, one very important commodity has increased in scarcity, leading to an increase in the price for the finished product the commodity is used to produce.

Consumers are paying more for pasta after heavy spring rain and record flooding prevented planting on more than 1 million acres in one of the nation’s best durum wheat-growing areas.

North Dakota typically grows nearly three-fourths the nation’s durum, and its crop is prized for its golden color and high protein. Pasta makers say the semolina flour made from North Dakota durum produces noodles that are among the world’s best.

This year’s crop, however, is expected to be only about 24.6 million bushels, or about two-fifths of last year’s. Total U.S. production is pegged at 59 million bushels, a little more than half of last year’s and the least since 2006, according to the U.S. Department of Agriculture.

The cost of pasta jumped about 20 cents in the past few months to an average of about $1.48 a pound nationwide…

…North Dakota durum fetched about $15 a bushel this spring but has dropped to about $11, due to the lack of buying and selling.

Still, that’s about twice what it sold for at this time last year, she said…

“This is one of the few crops we have that can have such an immediate impact on the consumer,” Goehring said. “This year, they will experience higher pasta prices.”

The story above is one played out in countless markets for commodities (such as wheat) and the goods they are used to produce (pasta, in this case) all the time. Due to poor weather and a particularly wet spring, farmers were unable to plant as many of their fields with wheat as they have in the past. Therefore, the 2011 wheat harvest is less than it usually is, meaning the supply of wheat has decreased. However, since there has been no fundamental change to the demand for wheat (we still eat pasta!) the relative scarcity of wheat is greater than in the past. Demand remained constant, while supply fell, therefore the relative scarcity increased.

The value of anything is based on its relative scarcity. In product markets, like that for wheat, value is conveyed by the commodity’s price. As the article says, the price of wheat is currently selling at “about twice what it sold for at this time last year”. At the current price of $11 per bushel, we can assume that the price last year was $5.50. However, the price reached as high as $15 earlier in the summer, indicating that the reduced supply of 59 milliion bushels, which is “a little more than half of last years” (which we’ll assume was around 100 million bushels), caused the price to peak at $15 this year. All this is a complicated way of saying that as the output of wheat fell, wheat prices rose because demand remained constant.

Additionally, the price of the product for which wheat in an input also rose. Pasta prices have jumped “20 cents in the past few months” to $1.48. Since the price of wheat is a resource cost for pasta producers, higher wheat prices lead to a fall in the supply of pasta, making pasta more scarce and driving the price up for pasta consumers.

All this can be demonstrated graphically using simple supply and demand analysis.

Based on the figures in the graphs above, the responsiveness of wheat consumer (which are mostly pasta producers) to the rising price of wheat can be easily calculated. Price elasticity of demand (PED) is the measure of consumers’ sensitivity to price changes. It is measured by calculating the percentage change in quantity following a price change divided by the percentage change in price. The quantity demanded of wheat fell by 41%, while the price rose by 272%, meaning that the PED for wheat is 41/272, or 0.15. This is considered relatively inelastic since such a large price increase led to a relatively small fall in the quantity of wheat demanded.

It is likely that if wheat prices remain elevated throughout 2011, next spring farmers across the American Midwest will have a strong incentive to plant more acres of wheat than they have in years past. Assuming the weather conditions improve and the fields are dry enough to grow wheat, it would be expected that a year from now wheat prices will be much lower than they are today, as supply returns to or exceeds historical levels next year. High prices for wheat today have harmed pasta consumers, but in the long run everyone, both pasta producers and pasta consumers, will likely enjoy lower prices thanks to the high prices of today.

This is how the market system works. When resources are under-allocated towards a particular good, as they have been towards wheat in 2011, price rises in response to the good’s increased scarcity. But the higher prices incentivize producers to allocate more resources towards those goods’ production, and over time the supply increases once more, reducing its scarcity and bringing the price back down.

Discussion Questions:

1. Why did wheat become more scarce in 2011, even though the demand for wheat did not change?
2. Interpret the claim that “wheat consumers are relatively unresponsive to higher wheat prices”. Can you think of a reason why this is the case? Can you think of an example of a product for which consumers would likely be much more responsive to a change in the price?
3. How does the high price of wheat and pasta in 2011 likely assure that a year from now, prices will be much lower than they are today, assuming there are not further problems with flooding in wheat growing areas?
4. How do prices “allocate resources” in a market economy? What do you think would have happened to the number of acres farmers would plant in wheat next year if instead of the price doubling this summer, it had been half of what it was in previous years?

One particularly witty student submitted his Economics Learning Log for our Elasticities unit with the following thoughtful poems.

On Price Elasticity of Demand:

Price may increase fast

Inelastic good’s demand

Stays in place for good

On Cross-price Elasticity of Demand:

Vodka drinkers fear

Russians tax it, prices soar

I’ll drink beer instead

On Income Elasticity of Demand:

Wages cut in half

No more decadent lifestyle

I miss my Rolls Royce

On Price Elasticity of Supply:

Demand for sweets down

Asbestos found in lollipops

Guess I’ll make fewer

Well done, Nick! Keep the haikus coming!

The following is an excerpt from chapter three of my upcoming IB Economics Textbook published by Pearson Baccalaureate

Understanding price elasticity of supply, which measures the responsiveness of producers to changes in the price of different goods, allows firm managers and government policymakers to better evaluate the effects of their output decisions and economic policies.

Excises taxes and PES: A tax on a particular good, known as an excise tax, will be paid by both the producers and the consumers of that good. When a government taxes a good for which supply is highly elastic, it is the consumer who ends up bearing the greatest burden of the tax, as producers are forced to pass the tax onto buyers in the form of a higher sales price. If the producer of a highly elastic good bears the the tax burden itself, it may be forced to reduce output to such a degree that production of the good becomes no longer economically viable. A tax on a good for which supply is highly inelastic will be born primarily by the producer of the good. The price paid by consumers will only increase slightly while the after-tax amount received by the producer will decrease significantly, but in the case of inelastic supply this will have a relatively small impact on output. A graphical representation of the effects of taxes on different goods will be introduced in chapter 4.

Price controls and PES: A common policy in rich countries aimed at assisting farmers is the use of minimum prices for agricultural commodities. The European Union’s Common Agricultural Policy (CAP) involves a complex system of subsidies, import and export controls and price controls, the objective of which is to ensure a fair standard of living for Europe’s agricultural community. The use of minimum prices in agricultural markets can have the unintended consequence of creating substantial surpluses of unsold output. Take the example of butter in the EU. The following excerpt was taken from the January 22, 2009 issue of the New York Times:

“Two years after it was supposed to have gone away for good, Europe’s ‘butter mountain’ is back… Faced with a drastic drop in the [demand for] dairy goods, the European Union will buy 30,000 tons of unsold butter. Surpluses… have returned because of the sharp drop in the [demand for]… butter and milk resulting partly from the global slowdown.

In response, the union’s executive body, the European Commission, said it would buy 30,000 tons of butter at a price of 2,299 euros a ton… Michael Mann, spokesman for the European Commission, said that the move was temporary but that if necessary, the European Union would buy more than those quantities of butter — though not at the same price.”

The situation in the European Union butter market can be attributed to an underestimate by policy makers of the responsiveness of butter producers to the price controls established under the CAP. A minimum price scheme of any sort, if effective, will result in surplus output of the good in question, but the 30,000 tons of unsold butter in Europe appears to exceed the expected surplus considerably. The graph below illustrates why:

A price floor (Pf) is set above the equilibrium price of butter established by the free market. Butter producers in Europe are guaranteed a price of Pf, and any surplus not sold at this price will be bought by the European Commission (EC). Assuming a relatively inelastic supply, which corresponds with the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run period (Ssr), the increase in butter production is relatively small (Qsr), resulting in a relatively small surplus (Qsr – Qd). In the short-run, the amount of surplus butter the EU governments needed to purchase was minimal. But as we learned earlier in this chapter, as producers of goods have time to adjust to the higher price, which in the case of the CAP is a price guaranteed by the EC, they become more responsive to the higher price and are able to increase their output by much more than in the short-run. Slr represents the supply of butter in Europe after years of the minimum price scheme. As demand has fallen due to the global economic slowdown, butter producers have continued to produce at a level corresponding with the price floor (Pf), leading to ever growing butter stocks and the need for the EC to spend, in this case, 69 million euros on surplus butter.

Understanding the behavior of producers in response to changes in prices, whether due to excise taxes or price controls, better allows both firm managers and government policy makers to respond appropriately to the conditions experienced by producers and consumer in the market place and avoid inefficiencies resulting from various economic policies.

Discussion questions:

1. Explain why the price elasticities of both demand and supply of primary commodities tend to be relatively low in the short run and higher in the long-run.
2. Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.
3. Discuss the importance of price elasticity of supply and price elasticity of demand for producers of primary commodities in less developed countries.

The elasticity, or perceived necessity of different products can influence the decision to introduce a tax. In Russia, two products, Beer and Vodka are being looked at as a potential sources of new government revenue. A proposed increase in the tax duties on beer, will potentially increase retail prices by between 20-30%. An increase in the price of one form of alcohol (beer) could shift demand towards other close substitutes, such as vodka or home brewed spirits. Hopefully, increased tax revenue will support the government finances and in the long run, the money could be reallocated to treat alcoholism.

An Economist article from last week gives a good analysis of this issue. Russia is a country where people drink 30 litres of hard liquor alcohol each year, six times more than the average European. Alcohol taxes are a sensitive subject, and the implications complex, but they need to be addressed.

The Economist – Russia raises tax on beer: Sin-Tax Error

Discussion Questions:

1. “Pushing up beer prices is far more likely to encourage drinkers to swallow even more vodka.” What does this quote suggest, about the cross elasticity of beer and spirits in Russia. Use evidence from the article so support your explanation.
2. The Russian government is suggesting adding a tax to beer.  What effect do you think this will have on the market price and market quantity of beer consumed.
3. The government wishes to impose a tax on these products. Assume a specific tax is imposed on each product. Assume the demand for beer is relatively elastic and the demand for vodka relatively inelastic and draw two graphs to show the effect on consumers and the relative tax burdens.
4. Explain what the aim of introducing taxes on vodka and beer is. Evaluate if the taxes will achieve the aims of increasing government revenue and reducing the social harms related to alcohol consumption in Russia.

It’s that time of the IB Economics course when I get to start teaching my year one students to write the dreaded Internal Assessment Commentaries. For their first IA, my students are writing a commentary on an article relating to Section 2.1 and 2.2 of the IB course, on supply, demand, market equilibrium and elasticities.

After reading a dozen or so out of my 38 students’ first drafts, I began to realize that what many of them needed was a clearer idea of what a good IB Economics commentary should look like. So I went back through past years’ commentaries and decided in the end just to write a sample commentary myself.

As you know, I do a lot of economics writing, so I thought this would be a breeze; I’d bust out a 700 word commentary modelling to my students what a top IA should look like. Well, I did it, but it proved to be much harder than I thought it would be. Why? Because after my first draft I was at 1100 words! The word limit, as IB students know, is 750, so I proceeded to spend as much time as it took me to write figuring out how to get it down to within the word limit.

Well, I did it. Below is my sample commentary for year one IB students. I do owe some credit to a past student of mine, Maren, whose article I stole and whose own commentary I adapted to write this one.

First, here’s the link to the article:

Where is Switzerland’s Cheapest Place to Live? – SwissInfo

And my commentary:

Introduction of theory:
Demand, supply and elasticity are basic economic concepts that when applied to different markets can help governments and individuals make informed decisions about things as basic as where to live and how to collect taxes.

Connection to article:
Recently, Credit Suisse conducted a survey and determined that Switzerland’s most expensive canton is Geneva, while the cheapest place to live is Appenzell Inner Rhodes, (AIR)

Analysis:
Demand is a curve showing the various amounts of a product consumers want and can purchase at different prices during a specific period of time. Supply is a curve showing the different amounts of a product suppliers are willing to provide at different prices. Equilibrium price and quantity are determined by the intersection of demand and supply. Price elasticity of demand (PED) indicates the responsiveness of consumers to a change in price, and is reflected in the relative slope of demand.

In the graph below, the markets for housing in Geneva and AIR are shown.

Demand for housing in Geneva (Dg), is high because of the many employment opportunities there. In addition, Geneva’s scarce land means supply of housing is low, resulting in a high equilibrium rent (Rg). Demand for housing in Geneva is inelastic, since renters in Geneva are less responsive to changes in rent compared to AIR, perhaps due to the perceived necessity of living close to their work.

Demand for housing in AIR (Da) is low, but supply is high due to the abundance of land. AIR is a rural canton with few jobs, therefore fewer people are willing and able to live there than in Geneva. Since living in the countryside is not a necessity, demand is relatively elastic, or responsive to changes in rent. The lower demand and greater supply make the AIR’s equilibrium rent relatively low.

The effect of a tax on property is a shift of the supply curve to the left and in increase in rents as landowners, forced to pay the canton a share of their rental incomes, raise the rent they charge residents.

In Geneva, property taxes are high, but this has little effect on the quantity demanded.

Geneva’s property tax shifts the supply of housing leftwards, as fewer landlords will be willing and able to supply properties to renters when the canton taxes rental incomes. However, the decrease in quantity demanded is proportionally smaller than the increase in the price caused by the tax, since demand for housing in Geneva is highly inelastic, or unresponsive to the higher price caused by the tax.

Renters in AIR are far more responsive to higher rents caused by property taxes, perhaps because living in AIR is not considered a necessity and there are more substitutes for rural cantons to live in. Renters in Geneva do not have the freedom to live in one of Switzerland’s many rural cantons, and are therefore less responsive to higher rents resulting from cantonal taxes.

Evaluation:
A tax decrease in AIR could lead to a significant increase in the number of people willing to live there, since renters are highly responsive to lower taxes. To some extent, housing in AIR and Geneva are substitutes for one another. Lower taxes in AIR would make living there more attractive, and subsequently the demand for housing in Geneva would fall putting downward pressure on rents there. People would move to AIR, attracted by lower rents, and commute to work in the cities. According to the article, this is already happening:

The disparity in the amount of disposable income… has increased the trend of people moving cantons for financial reasons… Economic necessities had led to an increase… of people moving address and opting to commute into work”.

There are many determinants of demand for housing in Switzerland, the primary one being location. High rents in Geneva are explained by the high demand for and the limited supply of housing. On the other hand, residents in AIR enjoy much lower rents, due to the weak demand and abundant land. Cantons should take into consideration the PED for housing when determining their property tax levels. Raising the tax Geneva will have little effect on rentals but could create substantial tax revenue. On the other hand, reducing taxes in AIR may attract many households away from the city to the countryside, drawn by the lower rents and property taxes.

Applying the basic principles of demand, supply and elasticity to Switzerland’s housing market allows households and government alike to make better decisions about where to live and how much to tax citizens.

Note: To see the full commentary including a cover page and highlighted article, click here

Consumers are interesting creatures to study. Economics offers us a unique set of tools for understanding the behavior of consumers in various markets. Elasticity is one of those tools, one which helps us understand how consumers will respond to the change in price of some goods more or less than others. Some of the questions about consumer behavior elasticity helps answer are:

• Why do governments place such huge taxes on cigarettes?
• Why did Apple cut the price of the new iPhone in half from the original one, despite the fact that it had so many new features?
• Why do movie theaters seem to raise their prices so steadily over the years, rather than doubling the price of tickets each year?

These and other questions can be answered by knowing something about the relative price elasticities of demand for the goods in question. Price elasticity of demand refers to the sensitivity of consumers to a change in price. For some goods, even the slightest increase in price will scare consumers away, while for others, price can go up and up and up and the quantity demanded won’t budge!

Here’s just one illustration of a good for which consumers are extremely sensitive to changes in price: Every autumn, around the city of Shanghai thousands of small farms harvest the Chinese watermelon, a small, green, juicy melon that looks and tastes the same regardless of which farm it came from. The farmers sell their melons to one of the hundreds of melon vendors who drive their big blue trucks into the city of Shanghai during about two weeks in October to sell the watermelons to the city folk who love their refreshing taste.

During the two weeks of the melon harvest, there are hundreds of blue trucks parked two or three per block all over the city. The hundreds of melon vendors sell an identical product, acquired at identical costs from thousands of farms using identical techniques for farming. In other words, the melon market in Shanghai during these two weeks is close to being perfectly competitive.

The price of melons is established through competition at something very close to the exact cost to the vendor of getting the melons into the city. Consumers know this, and therefore if one vendor tries to sell his melons for more than the equilibrium price, consumers will respond by buying NONE of that vendors melons. Conversely, if a vendor were to lower his price at all, rationally EVERY consumer would want to buy from that vendor, but since the price is already at the cost to the vendor, no vendor is able to lower the price without losing money. The outcome in the market for melons in Shanghai is that demand for melons is close to being perfectly elastic, meaning that consumers are completely sensitive to changes in price of watermelons.

Not all goods are like watermelons. In fact, for some goods demand is close to perfectly inelastic. Study the graph below, showing the relative elasticities of five different products, then answer the questions below in your comment!

Discussion Questions:

1. For which product is demand pefectly inelastic? Perfectly elastic? Unit elastic?
2. What relationship exists between relative slopes of demand curves and elasticity?
3. What are two characteristics of cigarettes that make demand for them inelastic?
4. What are two characteristics of heart transplants that make demand perfectly inelastic?
5. What are the characteristics of a good for which demand is perfectly elastic?

How can a commercial like the one below decrease the price elasticity of demand for a product like Molson Canadian beer? After this extremely successful commercial was released in Canada, Molson’s share of the beer market increased by 3%, while that of Labatt’s its largest competitor, shrunk by 3%.

The factors that affect the price elasticity of demand for a particular good are:
S -the number of  substitutes the good has.
P – The proportion of income the good is of the consumer’s income.
L - Whether the good is a luxury or a necessity
A - Whether the good is addictive
T - The amount of time consumers have to respond to a change in the price

Discussion Questions:

1. How can a successful advertising campaign reduce consumers’ responsiveness to changes in price of a good like Molson beer?
2. Why is it in the interest of a firm like Molson to decrease the price elasticity of demand for its product?

This article was originally published on May 12, 2008. It is being re-published since it relates to our current units in AP and IB Economics.

The Associated Press: Gas prices knock bicycle sales, repairs into higher gear

Greg Mankiw has an ongoing series of posts linking to articles illustrating the impact that rising gas prices have had on demand in markets other than that of the automobile.

One of the determinants of demand for goods and services is the price of related goods and services. As gas prices rise, drivers tend to switch from automobiles to alternative forms of transportation. A few days ago I blogged about the switch from tractors to camels in India, one illustration of the relationship between the price of one good and demand for its substitutes. Mankiw has so far linked to articles about the impact of high gas prices on demand for bicycles, small cars and mass transit.

These three “goods” are all substitutes for the most common form of transport among Americans, the private automobile (often times a gas-guzzler in “the bigger the better” America). When the price of a good like personal vehicular transport increases (in this case due to the price of an input required in private cars, gasoline), the demand for a substitute good will increase.

In the case of bicycles, evidence indicates that just such a change in demand is already underway in America today:

Bicycle shops across the country are reporting strong sales so far this year, and more people are bringing in bikes that have been idled for years, he said.

“People are riding bicycles a lot more often, and it’s due to a mixture of things but escalating gas prices is one of them,” said Bill Nesper, spokesman for the Washington. D.C.-based League of American Bicyclists.

“We’re seeing a spike in the number of calls we’re getting from people wanting tips on bicycle commuting,” he said.

Interestingly, the increase in demand for bicycle travel in response to high gas prices might be even more pronounced due to America’s sluggish growth, 4% inflation and rising unemployment. Real wages have seen little gain in the last couple of years as growth has fallen close to zero while prices have continued to rise. It may be possible that a fall in real incomes in America has spurred new demand for bicycle transportation, which could be considered an inferior good, meaning that as household incomes fall, consumers demand more bicycles for transportation.

Since bicycles represent such a drastically cheaper method of transportation, high gas and food prices, a weak dollar, and falling real wages accompanying the economic slowdown have had a negative income effect on American consumers, leading to increases in demand for inferior goods such as bicycle transportation

That said, having worked in a bike shop myself for two years in college, I can say that most consumers looking at new bicycles are not doing so because of falling incomes. Quite the opposite, in fact, indicating that new bicycles are normal goods (those for which as income rises, demand rises). However, the article states that in addition to increases in new sales, “more people are bringing in bikes that have been idled for years”.

It may be that while new bicycles themselves are normal goods, bicycle transportation as a whole is an inferior good. The increase in demand for new bicycles could be explained by the substitution effect (as the price of motor vehicle transportation rises, its substitute, bicycle transport, becomes more attractive to consumers) and at the same time explained by the income effect too (as real incomes have fallen, demand for the bicycle transport has risen).

This phenomenon is an excellent illustration of how the income and substitution effects work in conjunction to explain the inverse relationship between price and quantity demanded for automobiles (the law of demand), as well as the concept of cross-price elasticity of demand between two substitute goods.

Discussion Questions:

1. Both the price of substitute goods and income affect demand for a particular product. How have both the prices of substitutes for bikes and the income of bike consumers influenced the demand for bicycles in different ways?
2. What is the definition of an “inferior good” in economics?Do you believe bicycle transportation is an “inferior good”?
3. Are all bikes the same? Do you think demand for some bicycles responds differently to changes in income than demand for other bicycles?